The Senate is expected shortly to consider legislation, passed by the House in June, that
would repeal the federal estate, gift, and generation-skipping transfer tax by 2010. Among the
issues raised is whether the estate tax constitutes double taxation.(1)

Proponents of estate tax repeal claim the estate tax is unfair because the assets in an estate
already have been taxed once as income under the income tax. Therefore, they argue, the value of
the estate should not be taxed again. The premise on which this claim is based, however, is not
accurate. A significant portion of the value of all estates  and a majority of the value of the
largest estates  have never been subject to taxation as income. In our overall tax system, the
estate tax completes the income tax; it taxes income that otherwise would avoid taxation entirely.

Proponents of repeal also contend that the House bill addresses the problem of never-taxed
income by changing the way capital gains are taxed. The proposed changes in capital gains
taxation, however, would have limited effect and large amounts of income still would escape
taxation. In addition, the proposed changes are similar to ones enacted in the 1970s that were
found to be so complicated as to be unworkable and repealed before they took effect. If enacted,
the capital gains changes in the House bill are equally likely to be deemed impractical to
implement and to be repealed before they take effect (which would not be until 2010).

Gains on Assets Held Until Death Escape Income Taxes

Without the estate tax, capital gains included in an estate would never be taxed. Under
current law, the gain from appreciation of an asset is subject to the income tax only when the asset
is sold. Upon the sale of an asset, the difference between the purchase price and the sale price is
taxed as a capital gain. If a person holds on to an asset until he or she dies, however, the heirs
inherit the asset at its value at the time of the decedent's death. The gain on the asset from the
time of purchase to the time of death is never taxed under the income tax.

Some of the capital gains income that escapes taxation under the income tax may be taxed
under the estate tax. The appreciated value of the asset is included in the estate and, if the estate is
large enough, subject to taxation.

A substantial proportion of assets subject to the estate tax appear to be untaxed capital
gains. Estimates recently made by economists James Poterba and Scott Weisbenner, based on
data from the Survey of Consumer Finances, suggest that unrealized capital gains make up about
37 percent of the value of estates worth more than $1 million and about 56 percent of estates
worth more than $10 million.

Substituting Carry-over Basis Does Not Solve the Problem

The estate tax repeal bill the House passed includes a provision that, at first blush, would
seem to solve the problem of capital gains remaining untaxed in the absence of an estate tax. The
provision would require that for purposes of capital gains tax, heirs of very large estates must
value a portion of assets at the original purchase price of the asset. In other words, the original
"basis" would "carry over" to the new owner. If the heirs of such estates later sold the assets,
capital gains taxes would be due on the difference between the sale price and the original price the
individual who died paid for the asset.

Changing to a "carry-over" basis seems like it could be a partial substitute for the estate
tax, particularly in respect to previously untaxed income. In reality, a number of problems and
issues would prevent carry-over basis from working in this manner.

The carry-over basis provision in the House bill contains large exemptions. For each
individual who dies, $1.3 million in assets (based on the value of the assets at the time of the
individual's death) would be exempt from the carry-over provision. In other words, heirs would
pay capital gains tax on $1.3 million in assets (if they later sold these assets) based on the
difference between the sale price and the assets' value at the time the decedent died, rather than on
the difference between the sale price and the original purchase price the decedent paid for the
asset. An additional $3 million exemption would be available for bequests to a surviving spouse.
A couple could combine these exemptions to avoid capital gains taxes on up to $5.6 million in
inherited assets.

Implementation of this $5.6 million in exemptions per couple would be complex. If assets
have been held for a long time, records on the original purchase price could be missing, and it
could be difficult to establish the price for which the decedent purchased them. Still more
complexity would be added by opportunities for allocating these exemptions to best advantage. A
wealthy person (or executor) would have the opportunity to minimize capital gains taxes by
carefully choosing which assets would qualify for the exemption from the carry-over basis and
which assets would not, based on factors such as the likelihood of an asset being held or sold by
the heirs. In addition, once the assets were inherited, the record keeping and enforcement burden
of distinguishing between assets that retained their original purchase price as a basis and assets
that were revalued at death would be substantial.

The difficulties inherent in administering a carry-over basis provision are well known. A
carry-over basis provision was enacted a little over 20 years ago, but it never took effect because
of these complexities. The Tax Reform Act of 1976, which lowered the estate tax rate and
increased the amount of an estate exempt from estate taxes, applied capital gains taxes to inherited
assets when sold, based on the original purchase price of the asset. That provision was repealed in
1980, before it took effect. According to a Congressional Research Service report, the primary
rationale for repeal was the concern that the carryover basis resulted in great administrative
burdens for estates, heirs, and the Treasury Department.

The estate tax repeal legislation that the House recently approved makes its carry-over
basis provision effective in 2010, at the time the estate tax is fully repealed. Since the carry-over
basis is likely again to be found unworkable, there is a substantial probability this provision would
be repealed as the time for implementation approached.

Even if the carry-over basis provision ultimately were implemented, it would replace only
a fraction of the revenue lost as a result of estate tax repeal. A Congressional Budget Office
analysis of a carry-over basis proposal that does not include the types of exemptions included in
the House bill finds this proposal would replace only 12 percent of estate tax revenues. The carry-over provision in the House bill thus would replace much less than 12 percent of the estate tax
revenues lost due to estate tax repeal.